Demand for money, inflation/deflation & its implication

December 2nd, 2008

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Two years ago, we first covered the root cause of inflation in Cause of inflation: Shanghai bubble case study:

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money, in which the effect is the rise in the general level of prices.

As we have shown in yesterday’s chart in Australian money supply growth in September 2008, the supply of money in Australia had gathered momentum in the month to September 2008. In 12 months, the M3 money supply increased by 19.5%. The narrower definition of money, M1, increased by 8.3%. Does this mean that Australia is going to face runaway price inflation soon?

As a general principle, in the long run, there is a relationship between sustained monetary inflation and price inflation. In the same way, there is a relationship between a long-term lifestyle of eating excessive junk food and ill-health. In the interim, this relationship is more complicated. Using the junk food analogy, say that junk food eater dies of heart disease. What is the cause of death? Is it the heart disease? Or is it his sustained junk-food life-style?

Back to inflation, it is certainly possible to see continuing monetary inflation and slowing price inflation. In the US, the latest CPI figure even hinted of a price deflation! Therefore, in the short-term, there may not be a correlation between monetary inflation and price inflation. Part of the problem lies in the nature of how price inflation is measured and defined. As we said before in How much can we trust the price indices (e.g. CPI)?, price indices is a logically invalid idea. The implication is that it is possible to ‘define away’ price inflation and pretend that it is not a problem by torturing the statistics.

But setting aside the logical validity of price indices, what other dynamics is involved that can result in such non-correlation in the short-term? We will introduce one such dynamic- demand for money. This dynamic should not be confused with demand for credit. In lay-person’s terms, the demand for money is the desire for people to keep cash balance. As we wrote in The mechanics of deflation- increase in demand for holding cash,

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

Let’s say the quantity of money increases in the system. But if people want to increase their holdings of cash due to fear and uncertainty of the future, they will withdraw these cash from circulation in the economy. Consequently, prices fall. As we wrote,

When deflation mentality gets a stranglehold on to the minds of the people, no one will dare to borrow money out of fear. Also, when prices are falling, the money that one borrows will be worth more by the time the debt is due. There is no point in spending money because if one waits a little longer, prices will fall further. Central bankers can print as much money as they can, but in such a deflationary environment, no one will want to borrow them.

Today’s credit crisis is an example of this. Banks are hoarding cash and are unwilling to lend while borrowers are repaying debts with every scraps of cash that they can get their hands on. As a result, liquidity dries up in the system even though the supply of money is desperately increased by the central bank. In such a situation, some broader measures of money supply will be shown to decrease.

The opposite can also occur. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them.

In such a situation, the demand for money collapses. People want to keep their cash balance as low as possible as they constantly want to get rid of their cash for ‘stuffs.’ In the extreme case (i.e. hyperinflation), prices rise by the hour as people rush out to buy things the moment they are paid their wages, for fear that if they do not do so, price inflation will render their cash worthless.

Now, let’s look at what’s happening in the world. Merely 6 months ago, when oil prices was threatening US$150 and soaring food prices was driving people in poor nations to riots, the fear was price inflation. Today, with oil prices below US$50 and hardly any news on food prices, the fear is price deflation. Such extreme volatility is unprecedented in the history of humanity. It is this volatility and madness in prices that will wreck the real economy in the longer term (see Real economy suffers while financial markets stuff around with prices).

Where is the source of such extreme volatility?

As you may have already guessed by now, governments and central banks, in their attempt to solve the global financial crisis, is creating all these volatility through their interventions against the free market. Ironically, their ‘solutions’ are sowing the seeds of economic hardships for the next generation.

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  • http://fatcatsfinance.blogspot.com/ Paul

    So your coming down on the point of view that anticipates hyperinflation n the US. This is the kind of conclusion I may be coming to. (Please see my latest blog). Do you have similar thought on the Ozzie economy. I must admit I haven’t done the maths on Australia I just assumed that they were in a much better place than the states.

    I love to hear any opinions you may on these subjects of my blog entry

    Regards

    Paul

  • http://fatcatsfinance.blogspot.com/ Paul

    So your coming down on the point of view that anticipates hyperinflation n the US. This is the kind of conclusion I may be coming to. (Please see my latest blog). Do you have similar thought on the Ozzie economy. I must admit I haven’t done the maths on Australia I just assumed that they were in a much better place than the states.

    I love to hear any opinions you may on these subjects of my blog entry

    Regards

    Paul

  • http://contrarianinvestorsjournal.com Contrarian Investors? Journal

    Hi Paul!

    We’ve taken a look at your web site. It’s a pretty good effort for a non-economist.

    For the hard numbers, we recommend UWS Associate Professor Steve Keen’s website. He’s a debt expert and has the graphs on debt to GDP ratios on the US and Australia.

    As for whether deflation or inflation, we recommend our earlier article, Understanding the big picture in the inflation-deflation debate.

    Steve Keen believes that deflation is the most likely outcome. In a sense, he is right. But it is what governments and central banks do in response to the deflation threat that can turn this deflation into hyper-inflation. Steve Keen concedes that “over-the-top” fight against deflation can “trigger hyper-inflation” though he reckons that it is unlikely.

    Other experts like Marc Faber reckons that the greater the deflation threat, the harder the authorities will fight against it, which will in the longer run, result in hyper-inflation in the US.

    So, you can see, whether hyperinflation or deflation is the final outcome is something economics alone cannot answer.

    As for Australia, we have a very similar private debt profile as the US and UK. And central bankers around the world has the same Keynesian mindset. Assuming that the US will eventually become like Zimbabwe, it’s something that can happen to Australia too. But this is something we (or for anyone else) can predict or forecast. We have to open our eyes and see each step that the authorities take and prepare accordingly.

  • http://contrarianinvestorsjournal.com Contrarian Investors’ Journal Editor

    Hi Paul!

    We’ve taken a look at your web site. It’s a pretty good effort for a non-economist.

    For the hard numbers, we recommend UWS Associate Professor Steve Keen’s website. He’s a debt expert and has the graphs on debt to GDP ratios on the US and Australia.

    As for whether deflation or inflation, we recommend our earlier article, Understanding the big picture in the inflation-deflation debate.

    Steve Keen believes that deflation is the most likely outcome. In a sense, he is right. But it is what governments and central banks do in response to the deflation threat that can turn this deflation into hyper-inflation. Steve Keen concedes that “over-the-top” fight against deflation can “trigger hyper-inflation” though he reckons that it is unlikely.

    Other experts like Marc Faber reckons that the greater the deflation threat, the harder the authorities will fight against it, which will in the longer run, result in hyper-inflation in the US.

    So, you can see, whether hyperinflation or deflation is the final outcome is something economics alone cannot answer.

    As for Australia, we have a very similar private debt profile as the US and UK. And central bankers around the world has the same Keynesian mindset. Assuming that the US will eventually become like Zimbabwe, it’s something that can happen to Australia too. But this is something we (or for anyone else) can predict or forecast. We have to open our eyes and see each step that the authorities take and prepare accordingly.

  • Pete

    An excellent article! :)

    I think it really takes time before we can properly see the effects of these increases in money supply, and CPI inflation (yes because the CPI is flawed as you mentioned). It takes significant price changes to wake people up to price inflation.
    Adding 5c to the cost of a kilo of apples means nothing. Adding 50c gets noticed by a few. Adding $5 gets noticed by everyone.

    I guess we have to ask ourselves, when will inflation start actually affecting the CPI in a large way? I doubt it will be June next year, I think it will take longer (but should be a nice painful journey).

    Being a Gen Y’er (only barely), I grow impatient in my own strange lust to see the consequences of these inflationary actions. It seems unfortunately masochistic, but I guess I really just want to know if what we think will happen, will actually happen. Fighting herd mentality sure can take its toll on impressionable minds like my own.

  • Pete

    An excellent article! :)

    I think it really takes time before we can properly see the effects of these increases in money supply, and CPI inflation (yes because the CPI is flawed as you mentioned). It takes significant price changes to wake people up to price inflation.
    Adding 5c to the cost of a kilo of apples means nothing. Adding 50c gets noticed by a few. Adding $5 gets noticed by everyone.

    I guess we have to ask ourselves, when will inflation start actually affecting the CPI in a large way? I doubt it will be June next year, I think it will take longer (but should be a nice painful journey).

    Being a Gen Y’er (only barely), I grow impatient in my own strange lust to see the consequences of these inflationary actions. It seems unfortunately masochistic, but I guess I really just want to know if what we think will happen, will actually happen. Fighting herd mentality sure can take its toll on impressionable minds like my own.

  • David M

    What about a 30% increase in the price of flat screen TVs. I would say that is pointing towards price inflation. It might only be one bracket of items but with the sinking Aussie dollar we will be seeing a lot more. Possibly with a severe downturn in sales figures the manufacturers will pull their margins down in an attempts to gain sales and thus reduce the impact of such sudden price gains????

  • David M

    What about a 30% increase in the price of flat screen TVs. I would say that is pointing towards price inflation. It might only be one bracket of items but with the sinking Aussie dollar we will be seeing a lot more. Possibly with a severe downturn in sales figures the manufacturers will pull their margins down in an attempts to gain sales and thus reduce the impact of such sudden price gains????

  • http://contrarianinvestorsjournal.com Contrarian Investors? Journal

    Hi David!

    Yes, retailers tend to absorb currency fluctuations into their margins until they can no longer do so. Notice that petrol prices are the first to react to the fall in the AUD because petrol tends to be more price inelastic than consumer items. But if the AUD continues to tumble, then it will come to a point whereby the retailers can no longer absorb the increased import prices.

  • http://contrarianinvestorsjournal.com Contrarian Investors’ Journal Editor

    Hi David!

    Yes, retailers tend to absorb currency fluctuations into their margins until they can no longer do so. Notice that petrol prices are the first to react to the fall in the AUD because petrol tends to be more price inelastic than consumer items. But if the AUD continues to tumble, then it will come to a point whereby the retailers can no longer absorb the increased import prices.

  • Hagr

    ok I am confused, does the deflation increase or decrease the demand for money?